Introduction
In this Chapter, you will incrementally refine your financial accounting knowledge base by studying the Classified Balance Sheet and Multi-Step Income Statement. If you are not proficient in the base financial accounting rules, mechanics and terminology, then the material presented in this Chapter will be quite confusing. On the other hand, if you have mastered the foundational accounting language and are confident in your ability to analyze basic economic transactions and to complete a full accounting cycle as outlined in Chapters One through Four, you will find this Chapter to be very simple. Since I am writing this book for the best students who want to be challenged, refining a couple of financial statements isn’t enough meat for a full Chapter so I am going to supplement it with the most important (and most interesting and challenging) topic that an accounting student can study. I do not expect you to find easy answers, I want you to embark on an academic journey that begins by asking the question: Is There a Crisis in the Financial Accounting Paradigm?
Is There a Crisis in the Financial Accounting Paradigm?
In order to understand what this question means, please read Kuhn (1996) The Structure Of Scientific Revolutions[1] Chapter 8, The Response to Crisis and Chapter 9, The Nature and Necessity of Scientific Revolutions.
Let us assume that crises are a necessary precondition for the emergence of novel theories and ask next how scientists respond to their existence. Part of the answer, as obvious as it is important, can be discovered by noting first what scientists never do when confronted by even severe and prolonged anomalies. Though they may begin to lose faith and then to consider alternatives, they do not renounce the paradigm that has led them into crisis (p. 77).
If Kuhn’s theory is correct, it is unlikely that your accounting professor will question the validity of financial accounting. It is even less likely that the AICPA will begin to lobby the U.S. Government to radically change the nature of financial reporting requirements for public companies. After all, this act would reek of “the carpenter who blames his tools” (p. 79).
The Collapse of the Financial System
On a Friday afternoon in September 2008, the world financial markets collapsed. Over that weekend, the U.S. government decided to inject trillions of dollars into the system in order to reopen the banks on the following Monday. On top of direct cash infusions from the U.S. Treasury to private, for-profit financial service companies through the Troubled Asset Relief Program (“TARP”), nationalization of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Association (“Fannie Mae”), and security purchases by the Federal Reserve Open Market Committee (“FOMC”), the government assumed legal responsibility as counterparty on trillions of dollars of financial bets that were unsupported by sufficient capital. With the signature of President Bush, trillions of dollars of financial contracts that were valueless promises of failed; for-profit financial firms became obligations of the U.S Treasury. In 2011, we still do not know the full cost of the bailout, or even if it worked or was merely a ploy to buy time, delaying the inevitable collapse. (The true cost of the bank bailout | Need to Know) Some have suggested that poor individual financial literacy skills amongst American citizens led to the collapse of financial markets. Understanding how a system that was revered with dogmatic faith failed so completely and spectacularly will inform the question that seeks to discover the culpability of the financial accounting paradigm.
America at the start of the 21st century embraced a culture of conspicuous consumption financed by debt and a casino mentality that rewarded financial transactions, regardless of their economic merit. The repeal of depression-era bank regulations known as Glass-Steagall created a culture of lending without responsibility. Lenders profited by originating a loan, regardless of whether or not the borrower paid the money back. After all, the lender never put its own money at risk; it was someone else’s property, perhaps the assets of a government employee pension fund and after the loan was made, the banker had no remaining financial interest in the loan. American citizens were flooded with messages from all parts of society to get aboard the ownership society while they were able, prices were only going up and if they waited they could miss their opportunity at the American dream. Buy a house… or houses, any fool can make money in real estate. Just like the “stupid people” who tried to settle the Great American Desert resulting in the Dust Bowl[2], a generation of Americans destroyed their personal wealth by borrowing heavily to purchase homes and college educations at highly inflated prices. After the repeal of depression era banking regulations, America’s financial institutions became highly leveraged organizations seeking ever-higher investment returns while seemingly disregarding risk and the financial accounting profession seemingly did little to avert catastrophe. After all, bankers and financial accountants deluded themselves into believing that risk was non-existent because they mistakenly calculated that American real estate only increases in value. Individual loans that met certain standards (i.e. not subprime mortgages) were purchased by Government Sponsored Enterprises (“GSE’s”) Fannie Mae and Freddie Mac, guaranteed by the government, then turned over to the financial services industry to be marketed to private investors (including state and local government employee pension funds). In order to make the mortgage pools more lucrative, the financial services industry created side bets known as derivatives on the GSE backed mortgage pools. Some of these derivatives offered returns of several hundred percent, and best of all; the risk could be insured with an unregulated instrument called a Credit Default Swap. A single $100,000 home mortgage could be used to generate millions of dollars in financial products, many of which were granted impeccable grades from the rating agencies.
At the core of this scheme, an individual American was signing a note to purchase a house at an artificially inflated price. When the market crashed, the U.S. government covered the losses of the for-profit financial service firms who created the failed system but individual mortgage holders learned that the ownership society meant they were on their own. In addition, trillions of dollars in private savings, including public pension funds that were invested in the system were gone, funneled into the pockets of bankers and as a result, a generation of Americans will have virtually no retirement savings to supplement Social Security. At the same time, the resulting increase in government debt is threatening to significantly curtail future Social Security and healthcare benefits as well as pensions for government employees.
A Small Piece of the Picture Table 5.1
On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, which he characterized as "the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt." The Act mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and created the "Public Company Accounting Oversight Board," also known as the PCAOB, to oversee the activities of the auditing profession (http://www.sec.gov/about/laws.shtml#sox2002).
“SOX” was a complete and utter failure, which is not a surprise because it changed NOTHING within the financial accounting paradigm. The SOX approach was to “double-down” on the FASB, making market participants loudly swear their allegiance to the omnipotent group. While it generated a great deal of billable hours for CPA’s in the short-term, in the end it has had the net effect of damaging the profession and quite possibly hastening the collapse of financial markets.
Since the collapse of the financial market in 2008, what has been the governmental response? Kuhn observed that political revolutions (cultural reorganizations) aim to change political institutions in ways that those institutions themselves prohibit. Their success therefore necessitates the partial relinquishment of one set of institutions in favor of another, and in the interim, society is not fully governed by institutions at all. Is Kuhn’s observation relevant when evaluating the SEC’s and FASB’s ability to change the financial accounting paradigm? Recall from Chapters One and Two the purpose of financial accounting and consider the words of George Santayana “Fanaticism consists in redoubling your effort when you have forgotten your aim.[4]” I am challenging you dear student, to NOT forget the aim of financial accounting. You can be a part of the replacement of the current paradigm with a new improved paradigm that will improve the symmetry of information in financial markets and help the world achieve more efficient and democratic financial markets and a society with greater welfare for all.
Refining Financial Statements: The Classified Balance Sheet and Multi-Step Income Statement
The spreadsheets used in this chapter are available on Google Docs at Google Doc Worksheet. The companion YouTube lecture is available above. Please replicate this work, using paper and pencil, on columnar paper[5]. The remainder of this Chapter will be dedicated to identifying and recording certain transactions in the accounting records that facilitate the preparation of a Classified Balance Sheet and a Multi-Step Income Statement, both of which are the required by GAAP. The worksheet used in the Chapter is an extension of the Lizzie Incorporated case study that you have been using since Chapter Two. If you have mastered the material in the first four chapters, this section should only take a couple of hours (at most) to completely master.
The material presented in the Chapter is merely an incremental refinement of material that you already covered in Chapters One and Two. The FASB, drawing on Statement of Financial Accounting Concepts No. 8[6], has created standard rules that make these two financial statements more relevant to users by providing information that helps users make decisions and enhancing the predictive value.
· QC5. The fundamental qualitative characteristics are relevance and faithful representation.
o QC6. Relevant financial information is capable of making a difference in the decisions made by users.
o QC7. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value, or both.
Since financial statement rules MUST be applicable to all organizations in all industries, the refinements studied here are very minor.
Classified Balance Sheet Table 5.2
In Chapter One you memorized the accounting equation which is presented in the financial report as the Balance Sheet: Assets = Liabilities + Owners’ Equity. You also memorized that some asset and liability accounts were classified as current or long-term, but I didn’t tell you why at the time. In Chapter Four, you studied Periodicity and the Operating Cycle, a concept that is important to understand when learning how to classify an asset or liability as current.
· General Rule: If an asset or liability will expire in less than 1 year, it is classified as current. For example, if a Note receivable has a due date of 370 days from period end, it is non-current (synonymous with long-term). A debt that has a payment due date 360 days from period end would be classified as current.
o Exception: If the operating cycle of the entity is greater than 1 year, then the longer of the two would be the measurement used to classify current assets and liabilities. For example, Getya Drunk Whisky (from Chapter Four) had a 10-year operating cycle. Therefore, Its inventory would always be classified as current.[7]
Multi-Step Income Statement Table 5.3
In Chapter One, you memorized that the Income Statement presented: Revenue – Expenses = Net Income. Now you are going to study how to organize the revenue and expenses in the correct format.
1. Define NET sales as gross sales, less returns and allowances and sales discounts.
2. Making a distinction between product costs and operating costs. Subtract product costs (Cost of goods sold) from Net Sales to present Gross Profit.
3. Clearly identify non-operating revenue and expenses and income taxes.
Analyzing the Classified Balance Sheet and Multi-Step Income Statement Tables 5.4 and 5.5
Refining the financial statements can improve the predictive value of the financial statements as you can see in this intracompany analysis of Google Inc. and intercompany analysis of Wal-Mart Stores, Inc. and Target Corporation.
This analysis could enable a user of financial reports to compare two retailers to each other and to facilitate comparison of each company’s financial reports to companies outside of the retailing industry. Recall from Chapters One and Two that financial reporting is designed to facilitate symmetry of information so investors can choose the best I O U to buy.
MEMORIZATION ADDITIONS
SIX ACCOUNT TYPES (plus a song)– Table 5.6
In order to produce the Balance Sheet and Income Statement in accordance with GAAP, you will need to slightly refine your memorization from Chapter One. Recall the mnemonic D A E L O R (Dave And Ed Live On Red), two hard working college students Dave and Ed study non-stop into the wee hours of the night. To stay up and alert, they drink large quantities of Red Bull. We are going to add E I O to the end (think of the song Old McDonald had a farm.. e i e i o…)
Account Type | Definition | Natural Balance | Financial Statement |
Dividend | Assets distributed to stockholders | Debit | Retained Earnings |
Asset | Assets are probable future economic benefits obtained or controlled by a particular entity | Debit | Balance Sheet |
Expense | Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations | Debit | Income Statement |
Liability | Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future | Credit | Balance Sheet |
Owners’ Equity | The owners’ claim on assets (assets-liabilities) | Credit | Beginning Retained Earnings on Retained Earnings Statement, rest on Balance Sheet |
Revenue | Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations | Credit | Income Statement |
Expenses or Losses - Other Income or Gains - Other | Gains are increases (Losses decreases) in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owner | Gains and Other Income – Credit; Losses and Other Expense - Debit | Income Statement |
Recall the words of Newt Becker, the pioneering financial accounting educator who founded the Becker CPA Review Course, coined the phrase “an ounce of memorization is worth a pound of logic.”
Common Account Names – Table 5.7
Account Type | Account Name |
Dividend | Cash dividend |
Asset | Current: Cash, Accounts receivable, Interest receivable, Inventory, Supplies, Prepaid rent, Prepaid insurance, Prepaid expense Long-term: Land (used in business), Property Plant and Equipment, Accumulated depreciation (contra-asset), Patent, Long-term investment |
Expense | Cost of goods sold, Income tax expense, Salaries expense, Maintenance expense, Rent expense, Selling expense, Shipping expense, Insurance expense, Rent expense, Unearned revenue, Utilities expense |
Liability | Current: Accounts payable, Note payable (depending on term of note), Income taxes payable, Interest payable Long-term: Mortgage payable |
Owners’ Equity | Common stock, Retained Earnings |
Revenue | Sales revenue, Sales returns and allowances (contra-revenue), Sales discounts (contra-revenue) |
Expenses or Losses - Other Income or Gains - Other | Expenses or Losses – Other: Interest expense, Loss on disposal of equipment Income or Gains – Other: Interest income, Gain on sale of equipment |
Identifying, Analyzing and Recording Transactions
Selling a Fixed Asset at a Loss Table 5.8
Lizzie Incorporated purchased a piece of equipment on December 30, then returned it the next day. The mean old equipment dealer only returned $625, so Lizzie Inc. suffered a loss. Since Lizzie Inc. is not in the business of selling equipment (it sells toy mice), it is important to capture this transaction in an account that can be clearly identified as non-operating.
Customer Returns Merchandise 5.9
On November 30, Lizzie Inc. sold merchandise to a customer on account (je #7). On December 31, the customer returned $500 of merchandise. Rather than reduce the Sales account, Lizzie Inc. records returns to a contra-revenue account so it can track the level of sales returns. Since Lizzie Inc. uses a periodic inventory system; the change to inventory will be picked up during the physical inventory at yearend. 
Since the customer owes Lizzie Inc. $500 less, the Accounts receivable is reduced with a credit entry.
Recording Interest Income and Interest Expense Table 5.10
When reconciling the bank account (bankrec), Lizzie Inc. discovered that it had earned $6 of interest on its checking account (je #13). The accrual of interest expense (je #14) was covered in Chapter Four and the calculation is on the “Accrual Calculations” tab in the Google worksheet.
Since companies have different options for financing (issuing stock, paying dividends, mortgages, etc), both interest income and expense are included in “Other” on the Income Statement. This enables readers of financial reports to isolate and compare the operating performance of an individual organization.
Recording Income Tax Expense Table 5.11
Usually one of the last journal entries of a period for any company is the accrual of the income tax liability that arose during the period. You will study this topic more in detail when you take Intermediate Accounting… I promise it isn’t that hard.
Just like any other accrual of a liability, an expense is the offsetting entry.
Now, post the journal entries to the ledger, total the ledger and complete the accounting cycle. Do this a minimum of three times without error.
Kuhn Paradigm Science… The Importance of PRACTICE
Kuhn’s observations can be extrapolated to society at large because a scientific community is a social system organized around a single paradigm just as society is organized around an economic paradigm. The framework is the foundation upon which the community is built, providing its rules for communication and social interaction. Without the framework the community does not exist. Understanding the framework, how it was established, its rules, terms of communication, tools, boundaries and even its known flaws is invaluable in understanding its product. Kuhn (1996) declared that the paradigm is not theoretical for its members, rather, it is part of their life and each member has personally observed evidence of its accuracy.
If, for example, the student of Newtonian dynamics ever discovers the meaning of terms like force, mass, space, and time, he does so less from the incomplete though sometimes helpful definitions in this text then by observing and participating in the application of these concepts to problem-solving (p. 46-47).
What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm.
[1] I really want you to get the book, but a Professor at Emory has done a great job summarizing the work http://www.des.emory.edu/mfp/Kuhn.html.
[2] Those who cannot remember the past are condemned to repeat it… http://www.npr.org/templates/story/story.php?storyId=5128581
[3] http://www.sec.gov/about/laws.shtml#sox2002
[4] Life of Reason (1905) vol. 1, Introduction
[5] http://www.printablepaper.net/category/columnar
[6] http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175821997186&blobheader=application%2Fpdf
[7] I like to brag that I have done everything there is to do in accounting… but I have never had the opportunity account for an entity with an operating cycle longer than one year.
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